The Federal Research and Development (R&D) Tax Credit has significantly enhanced during the past year, offering taxpayers additional benefits and improved clarity for one of the most attractive tax incentives offered in the federal tax system. On the heels of the December 2015 passage of the PATH Act that permanently extended the R&D Credit, the IRS cleared-up some of the ambiguity surrounding the Credit’s Internal Use Software (“IUS”) provisions through issuance of the long-awaited final IUS Treasury Regulations.
The IUS regulations cut through ambiguity to offer taxpayers greater clarity regarding what does, and what does not, constitute “Internal Use Software” for the purposes of the R&D Credit.
Internal Use software (IUS) Background
For the purposes of claiming the R&D Credit, taxpayers would almost always prefer that their developed software programs or systems not fall within the definition of IUS.
Claiming a R&D Tax credit is dependent on a particular research activity meeting a four-part Statutory Test, as outlined in I.R.C. § 41. With regard to software solutions developed for the taxpayer’s own internal use, the research activity must also qualify under an additional three-part High Threshold of Innovation Test.
While there is some overlap between the two tests, research activities undertaken to develop IUS must meet seven conditions in order to qualify for the R&D credit, a burdensome requirement for many taxpayers. Given those conditions, any guidance offering a more-precise definition of what constitutes IUS gives taxpayers additional “ammo” to qualify software development as non-IUS and avoid the onerous High Threshold of Innovation Test.
New IUS Regulations
The new IUS regulations do not significantly differ from the proposed regulations, which were lauded as being taxpayer-friendly upon their release in January 2015. Below are the two biggest takeaways from the new IUS regulations.
Software To Perform General & Administrative Functions
Final regulations define IUS as software developed to perform “General and Administrative Functions”, which are further grouped into three categories:
- Financial Management – Functions that involve internal financial management and associated record-keeping.
- Human Resource Management – Functions regarding the taxpayer’s internal workforce.
- Support Services – Functions supporting the taxpayer’s day-to-day operations, such as data processing or facility management.
While some argue that the final regulations do not adequately draw a line in the sand regarding what constitutes IUS, others are happy to see more precision as to what constitutes a “back-office” function.
What Software Is Considered Non-IUS?
Perhaps just as illuminating, the final IUS regulations also clarify what software is not considered IUS. While the regulation’s definition of “software not developed primarily for internal use” does not itself offer any clarity, the regulations do provide informative illustrations of non-IUS.
The final regulations hold that software developed to be “commercially sold, leased, licensed or otherwise marketed to third parties” constitutes non-IUS, as well as software developed to enable a taxpayer to interact with third parties or allow them to initiate functions on the taxpayer’s system.
Generally, this means that software is considered non-IUS if it was developed primarily to interact with third-parties. The extent of the external usage is the controlling factor in determining whether a particular software system falls outside the definition of IUS.
Contact Bennett Thrasher
While the final IUS regulations offer much-needed clarity regarding what constitutes IUS for the purposes of the R&D Tax Credit, taxpayers in the software development arena would be wise to carefully evaluate all R&D activities to ensure that they are properly classifying software as either IUS or non-IUS. For more information and assistance with the R&D Tax Credit, please contact Betsi Barrett or call us to schedule a consultation.